SLIDE 1 New Baldness Drug Is an Older Product at a Premium Price
What is this an example of? Given Mercks pricing strategy for which market is demand more inelastic? Is the baldness market really more inelastic than the prostrate market? Can you detect the fallacy of sunk costs?
Prices and Markets
Session 8 Implicit Price Discrimination
SLIDE 2 Q P MC# Demand# Variable#profit# “No$money$is$le,$
High valuation customers Lower valuation customers
Perfect'Price'Discrimina.on' Q P MC# Demand# MR# Variable# profit# Uniform'Pricing' Op5mal# price#
“A key step is to avoid uniform pricing. Pricing to specific customer groups should reflect the true competitive value of what is being provided. No money is left on the table...”
- A. Miles, Pricing, Boston Consulting Group.
Recap: Perfect Price Discrimination
Theme of todays class: How Economists Hunt Elephants? ECONOMISTS don't hunt elephants, but believe that if elephants are given sufficient incentives, they will hunt themselves.
SLIDE 3 This Session Implicit Price Discrimination
- 1. Implicit Price Discrimination
- 2. Airline pricing
- 3. Bundling
Next Session Perfect Competition
This Session
Uniform Pricing (One Price for All) Explicit Market Segmentation (Different Prices for Different People)
Last 2 Sessions
A Classic Pricing Dilemma: You know composition of market, but cannot identify valuation of individual customers. – Implicit Market Segmentation (Screening) – (Different Choices for Different People)
SLIDE 4 How to Get Elephants to Hunt Themselves
Cappuccino for high WTP: £2 Cappuccino for low WTP: £1 Cappuccino (no frills) 1.85 Hot Chocolate (no frills) 1.89 Café Mocha (mix them together – I am special) 2.05 White Chocolate Mocha (use different powder – I am really special) 2.49 White Chocolate Mocha Venti (I am greedy) 3.09 Fair Trade Coffee at Costa Coffee Cappuccino for the concerned: £1.85 Cappuccino for the unconcerned: £1.75 Premium paid to farmers in Guatemala: 50p per pound of coffee beans On a cappuccino that translates to a cost increase of less then a penny a cup The Elusive Short Cappuccino at Starbucks A 20 oz cappuccino is an oxymoron
A Requisite for Screening
Options cannot differ only by price; you need another dimension or product characteristic about which customers have different preferences.
- Called: Screening Mechanism
- Must be correlated with willingness to pay
Real World Examples:
- 1. Product differentiation
Coffee pricing, Airline pricing This session
Cable TV channels This session
SLIDE 5
Basic Terms and Concepts
Menu The set of options you offer your customers. Objective Customize trades in the menu such that high valuation consumers freely choose the more expensive option on the menu. Make sure menu satisfies two constraints: Participation constraint Customer prefers the deal over not trading at all. Self-selection constraint Customer prefers the deal you have designed for him/ her over other deals in menu.
A Simple Example: Coupons
Coupons and mail-in rebates require an effort on the part of the consumer to redeem (usually, must be mailed in for refund) Coupons and rebates – a rather expensive way to cut prices
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Coupons must be printed and circulated
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Redeeming them is expensive: applications must be processed, checks cut and mailed So why issue coupons? Why not just cut prices?
SLIDE 6
Coupons
An Alternative Explanation
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Consumers are not equally likely to redeem coupons
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Correlation between a consumers willingness to pay and the likelihood that he/she redeems What is the likely direction of this correlation?
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Rebates discriminate among consumers according to the opportunity cost of their time
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...and for this to work it is essential that redemption is made to be a time-consuming hassle
SLIDE 7 Coupons As a Screening Device
Demand
C B
Old price: P0 New price: P1
Q P ($) A Q0 Q0+1 Without rebates, P 0 may be optimal because the firm gives up A+B to sell additional output so MR = C – A – B. With rebates, only some consumer redeem, so MR = C – A, and a price cut is more attractive. Note that here there are effectively two prices in the market.
redeem dont redeem
Cat food 0.49 1.13 Frozen entrée 0.60 0.95 Gelatin 0.97 1.25 Spaghetti sauce 1.65 1.81 Shampoo/conditioner 0.82 1.12 Soup 1.05 1.22 Hot dogs 0.59 0.77 Cooking oil 1.21 1.32
Price Elasticity Product Nonusers Users Price Elasticity of Demand for Users
SLIDE 8 Other Examples of Implicit Price Discrimination
Hardcover vs. Softcover Books Versioning/Damaging Happy hour; Outlet malls Super Thursday: Regular Thursday sales in supermarkets Damaged Goods:
- IBM laser printers; Mathematica student version; Intel processors
- Federal Express offers both morning and afternoon delivery. FedEx does
not deliver afternoon packages in the morning, even if they arrive in time for morning delivery. Instead they will make two trips to the same location. Home Premium 214.99 Professional 319.99 Ultimate 337.99
Hotel Price Price (Lowest First) (Highest First) Francisco 1 Hotel £146.80 £169.50 Asturias Hotel £147.65 £170.35 Tryp Washington £174.00 £196.70 Tryp Rex £174.00 £196.70 Tryp Menfis £184.20 £206.90 Tryp Ambassador £189.30 £212.00 Vincci Soho £192.70 £215.40 Gran Melia Fenix £257.30 £280.00
Ingenious Price Discrimination
Metro Getaways: http://metro.driveline.co.uk/ Two-night break in Madrid on 4th August 2006, with flights from London
Actual quotes for tickets on Feb 27, 04:
- 1. Minneapolis-Newark: go: Wed, March 20, return: Fri, March 22: $772.50
- 2. Minneapolis-Newark: go: Wed, March 20, return: Wed, March 27: $226.50
- 3. Newark-Minneapolis: go: Fri, March 22, return: Wed, March 27: $246.50
SLIDE 9 This Session Implicit Price Discrimination
- 1. Implicit Price Discrimination
- 2. Airline pricing
- 3. Bundling
Next Session Perfect Competition
The Mother of All Discriminatory Pricing: Airline Pricing
Airlines like to segment the market based on valuations, but valuations are not observed
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On the other hand, valuations are correlated with time sensitivity
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In general consumers with higher valuation are less likely to accept:
- Saturday night stay
- A 14-day advance ticketing ,..etc.
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Solution: Create a product line based on artificial restrictions. These simply annoy the customers, and have little or no bearing on their cost of operation
SLIDE 10
Screening with Differentiated Products
Scenario: Airline has B business customers and L leisure customers. Type of Customer Valuation Unrestricted Restricted Business $1000 $600 Leisure $600 $500 Cost per ticket = $ 300 (Same for restricted and unrestricted tickets) – Explicit Market Segmentation?? –
Pricing of Only Unrestricted Tickets
Option 1: Charge $1000 and sell only to Business travelers Profit = (1000-300)*B = 700B Option 2: Charge $600 and sell to both Business and Leisure Profit = (600-300)*(B + L) = 300 (B + L)
SLIDE 11
Screening with Restricted & Unrestricted Tickets
Option 3: Charge $900 and sell unrestricted tickets to Business travelers Charge $500 and sell restricted tickets to Leisure travelers Profit = (900-300)*B + (500-300)L = 600B + 200L This is Screening or Implicit Market Segmentation
Comparison of 3 Options
(A) sell only unrestricted tickets at a price of ___________ to business travelers only; Profit: (B) sell only unrestricted tickets at a price of ____________ to all travelers; Profit: (C) sell unrestricted tickets to business travelers for ____________ and restricted tickets to leisure travelers for __________. Profit:
SLIDE 12 10000 20000 30000 40000 50000 60000 10 20 30 40 50 60 70 80 90 100 % Bus. Travelers (B ) Profit
B C A
B Best C Best A Best
- Even if you cannot explicitly segment the market dont lose
heart – implicitly segment the market!
- Offer a menu of options and try to come up with a creative
screening mechanism
- Try product differentiation, versioning, inter-temporal pricing,
damaging, bundling (see this next time) – these achieve price discrimination Wrap Up
SLIDE 13 Bottom Line
Do not ignore the composition of your market! Marketing guru says: the right product for the right customer at the right price, Economist sage says: segment, differentiate, then segment some more!!
- 1. Find products where you can effectively prevent high-end consumers
from buying the low-end product
- 2. If you cant, implicitly segment the market – design a product line through
bundling, differentiation, versioning, inter-temporal pricing, damaging that achieves price discrimination
SLIDE 14 This Session Implicit Price Discrimination
- 1. Implicit Price Discrimination
- 2. Airline pricing
- 3. Bundling
Next Session Perfect Competition
- Selling several goods in one bundle
" Hardware and software " Software suites " Sports/Concert tickets " Auto accessories
Bundling
SLIDE 15
Exercise 6.6: Screening via Bundling
Pricing of the polo shirt and the dinner party at the Lebanese week. Highly segmented, with only three types of customers: Type of Customer Valuation Polo Shirt Dinner A $50 $5 B $40 $40 C $5 $50 A customer may buy either the polo shirt or the dinner. – Benchmark: Perfect Price Discrimination – – No Bundling –
SLIDE 16 – Pure Bundling – – Mixed Bundling – The Genius of Dell??
! Shoppers don't understand why retailers offer this kind of promotion when it's
no better for customers and no more profitable for stores than a half-price sale….
- Washington Post consumer columnist Margaret Webb Pressler
Hmmm…it is more profitable than a half-price sale!! Pizza: Valuation for 1st: $15.01; Valuation for 2nd: $5.01; MC = $2 BOGO at $20 Profit = 20 – 4 = 16 2 Pizzas for $10 each Profit = 10 – 2 = 8
What is this? Buy One Get One Free (BOGO)
SLIDE 17 This Session Implicit Price Discrimination
- 1. Implicit Price Discrimination
- 2. Airline pricing
- 3. Bundling
Next Session Perfect Competition
Next Session: A $2 billion Question!!
Should Alusaf invest $2b in building the hillside plant? Key question: can we predict tomorrow’s aluminum prices? Construct the industry supply curve for primary aluminum using the data provided on the course website.
- One Powerpoint slide with the costs you think are variable
and the costs you think are fixed.
- One Powerpoint slide with the industry’s supply curve.
Groupwork -- Send by Sunday at noon for discussion in sessions 9, 10 and 11 Reading: Alusaf’s Hillside Project – case in the course pack
SLIDE 18 New Baldness Drug Is an Older Product at a Premium Price
What is this an example of? Explicit market segmentation. Given Mercks pricing strategy for which market is demand more inelastic? It seems that the baldness market is more inelastic – higher price charged here Is the baldness market really more inelastic than the prostrate market? There are many possibilities here; these suggest overall that the baldness market is more elastic than the prostrate market, which contradicts our previous conclusion. Either we are missing key information or Merck is making a mistake. Can you detect the fallacy of sunk costs? The article repeatedly says that Merck charges a high price for baldness medication because it must recover R&D and advertising costs.
